The Million Dollar Ski Boat
Research being conducted by the Employee Benefit Research Institute (EBRI) and other reputable firms indicates that too many young workers spend money they get from their retirement plan when they change jobs. Sure, the amounts of money seem small to them at the time, and they have a long life ahead of them to accumulate more retirement assets.
However, what becomes clear is that these individuals do not fully comprehend the magic of compound interest. It is said that Albert Einstein once commented that the most powerful force in the universe was compound interest. While Einstein may have been speaking a bit tongue-in-cheek, he is probably correct in that this force has a profound effect on all of our lives, and especially upon our financial futures.
Compound interest works this way – if you have $100 and it earns 5% interest, the $5.00 you earn in interest is added to your original investment, making the total now $105. The next year, not only will your original $100 earn interest, but the $5 gain from last year will also earn interest, compounding the earnings. Over time, the effect of compound interest can be huge.
For example, let’s assume you put $100 into an investment that pays 5% every year for 40 years. If you withdrew the interest your $100 earned each year rather than letting it compound, over 40 years you would have withdrawn $200 (40 x $5), plus you would still have your original $100. Not bad, a 200% gain on your hundred bucks over time.
However, if you allow the interest earnings to stay in the investment along with your original $100, the numbers are quite different. After 40 years of 5% earnings, your $100 would be worth just over $700. Netting out the original investment, your gain would be about $600, or three times what the interest withdrawals would have amounted to.
One of my favorite illustrations to drive home the power of compound interest is what I call “The Million Dollar Ski Boat.” It’s not only my favorite because it highlights the importance of investing while you’re young, but being an avid boater, I can identify with the dilemma the subject of this illustration is going through. It goes like this:
Young John Doe is 28 years old and has accepted a position with a new company. He worked for his former employer since he graduated from college at age 22, so he has six years of service and is 100% vested in his 401(k) plan balance of $25,000. Of this amount, $10,000 represents his pre-tax contributions, and the remaining $15,000 represents his employer’s matching contributions, plus earnings.
John’s new employer also sponsors a 401(k) plan, and it has a provision that allows new employees to roll over any balance from a previous plan into the new employer’s plan. Rather than rollover his $25,000 from his previous plan to the new one, John elected to take a full distribution from his old plan and use the 60-day rollover period to think about what to do. Under current law, the former employer is required to withhold 20% ($5,000) of the total distribution as a reserve for income taxes, so John receives a check for $20,000.
Poor John is already at a disadvantage. Under the law, he could have elected to have a direct rollover (all $25,000) from his former employer’s plan into either his new employer’s plan, or into an individual rollover IRA. By taking a direct distribution to himself, $5,000 has been withheld for taxes. If he eventually rolls the full distribution over to an IRA within the 60-day time window, he will get back the $5,000, but only as a tax refund after he files his taxes next year. Thus, he must either come up with the $5,000 out of other resources now, or rollover only the $20,000 he received, leaving a $5,000 taxable distribution.
When springtime rolls around, John is still within his 60-day rollover period, but sees an ad for a super deal on a new ski boat for only $18,000. Even with tax, additional equipment, etc., the $20,000 he got from his plan will more than cover the costs. Now, John goes into full justification mode. He’s got to rationalize a good reason to use the money on a boat rather than rolling it over for retirement. The thinking process might go something like this:
* He’s only 28, so his Social Security retirement age of 67 is almost 40 years away – more than enough time to make up a measly $20,000;
You will note that not all of the above reasoning makes sense. That’s the nature of justification. It doesn’t have to make sense, it just has to sound good.
So, let’s see what John has given up. In exchange for a tax-deferred benefit representing the retirement savings accrued during his six years of hard work, he has purchased a depreciating asset. Not only that, but a depreciating asset that has also been described as “a hole in the water into which you throw money,” but that’s a subject for another time.
The true cost of John’s decision is not just the tax bill on the distribution, or even the penalty tax due because he is under age 59 ½. The real cost is what he gives up at retirement by cashing out his accrued retirement benefit. By the time John retires in 39 years at age 67, the boat will be a distant memory. However, had he maintained his distribution in a tax-deferred account, here’s what he might have accumulated:
What seemed like a relatively small amount of money to John at age 28 can grow into a sizable sum of money via the miracle of compound interest over many years. Would you trade $25,000 now for a potential benefit of anywhere from $240,000 to over $1,000,000 at retirement? Or, let’s put it another way: Would you pay a million dollars for an $18,000 ski boat? Our friend in the above example might do just that, and the attitude toward retirement that he exhibits is far more common than you might suspect.
With Social Security’s solvency on shaky ground and many employers cutting back on traditional pension plans, it just doesn’t make sense for anyone to spend their retirement plan distributions rather than rolling them over.
Think about it!
P.S. – If you are facing a rollover decision now or in the near future, I urge you to call one of our Investor Representatives at 800-348-3601 to discuss your options.
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